Business valuation is a common process where the economic value of a company unit or business is determined through a number of different means. Creating an accurate business valuation is critical to ensuring that both sides of an eventual sale are getting a fair deal, or that your business worth is accurately reflected for tax reasons.
As a business owner, you will need to have your organisation valued at some point, but if it’s your first time, the process may appear confusing or complicated. While we would always recommend recruiting a professional to help you through the different areas, it’s still important that you understand the basics. To help you, we’ve created this simple guide that outlines everything you should know.
Three questions to ask yourself before starting
Getting a good valuation depends on a number of external factors. Here are three of the main areas to keep in mind as you start your journey.
1. What do others think your business is worth?
One of the challenges of business valuation is that ‘value’ can mean different things to different people. For instance, a particular business owner may believe that their organization is an essential service to the local community, and is therefore very valuable. However, to a buyer who is only focused on the financial side of things, the value will simply lie on how much money the business is making both in the short and the long-term.
2. What are the current market conditions?
The supply and demand of what a business offers also plays a large part in determining overall value. A business may have a bad month due to external factors or may have an unusually good one; making the value higher or lower than it actually is.
Also consider supply and demand. If the market is flooded with similar businesses, your value may be lower. However, if a business is in a niche or in high-demand, it’s valuation will naturally be worth more.
3. What is the difference between price and value?
It’s important to differentiate the price of the company from the value. The value of a company is what potential buyers will pay, based on how successful the company will be for their specific goals and interests. The price is the actual monetary worth of the company at the time of sale, based on the current market and how much the overall assets are priced.
The three main ways to measure business value
Broadly, there are three different ways that you can measure the value of a business: Either through available assets, the current market, or the actual income.
1. Valuation through assets
By using an asset approach, you’ll be looking at the business purely in terms of assets and liabilities, where the balance sheet tells the entire story of the business.
Assets refers to items of value owned by the business. For example, products, inventory, office furniture, equipment and any office space. Bear in mind that assets can also include non-physical elements such as software and patents. You may even have assets you didn’t even know about, so make sure that you understand your true value. To find out more, read our article on exploring your hidden assets.
Your assets will also include your Debtors Ledger, which essentially records the part of a company’s accounts that shows money owed to the company. By having a healthy Debtors Ledger where you are clearly owed money, you can use this to show that the company has more value.
Liabilities are what the company owes, and is therefore money that is ‘going out’. Examples of business liabilities include outstanding bills, rent, taxes, employee salary and other expenses.
Sometimes, it’s not quite as simple as just subtracting one from the other. It will be tempting to just look at the balance sheet to see what’s coming in and going out, but this might not be the best way to see the whole picture. For instance, hard numbers might not reflect intangible assets and liabilities, such as patents, trademarks and proprietary ways of conducting the business. It might be possible that these kinds of assets have a much higher monetary value or liability than first imagined.
2. Valuation through the market
By knowing the market, you’ll be able to justify the asking or selling price to truly get the best deal in your business valuation.
However, the world of business is fast-moving and you will need to do your research. For instance, if you’re looking for a business to buy, it’s important to look around and see what similar businesses are being sold for, before being able to make a more informed decision. The same principle applies if you’re selling, so that you can avoid pricing yourself out or selling too low.
With so many variables, there needs to be a way for both buyers and sellers to feel comfortable. This is where Fair Market Value comes into play. The Fair Market Value of a business will be established when willing buyers and sellers reach an agreement, where both sides have all of the facts and neither side is being forced in any way to carry out the transaction.
3. Valuation through income
For many buyers or sellers, the income approach is the most direct way to decide on what they want to do. It gets right to the core of commerce and just looks at the money being made. After all, buyers and sellers are naturally going to want to get the best deal possible, for the least amount of effort. If the economic benefits aren’t there, then there’s no point.
By taking the route of Income Valuation, you’ll be able to understand what kind of money the business is currently bringing in, what the potential is for more, and what the risks might be. Another reason why buyers and sellers might prefer this approach is that it shows the business value in the present, instead of in the past or the future.
To get this real-time look at the income, you can take two different routes: Capitalization or Discounting.
Capitalization -This approach is best suited for businesses with predictable, steady and regular earnings. To put it in the simplest possible way, Income Capitalization occurs when the expected business earnings are divided by the Capitalization Rate, which is calculated through the net income and current market value of the asset.
The idea here is that the business value is defined through its earnings, in the context of the wider market. For instance, if the Capitalization Rate is 44%, then you can assume the business is worth four times its annual earnings.
This is one of the more complex valuation methods, so we recommend working with experienced accountants and valuation professions for this particular route.
Discounting – Occurs when you forecast business income over a predefined period of time; usually over a number of years. Then, a Discount Rate (the required rate of return to make a business acquisition worthwhile) is calculated which estimates the risks of not receiving that income in time, if at all.
The final step is estimating what the business is most likely to be worth at the end of the forecasted time. If the business is expected to keep running beyond this period, there will be Terminal Value (also known as Residual Value), which, when discounted together with forecast earnings gives you a pretty good idea of what the business is worth at present.
If your business is struggling with cash flow and it’s affecting your valuation, you can also look to unlock the cash in your sales invoices by using our Invoice Finance solutions.
Which method is the best?
When valuing a business to get the best possible deal, the method and process you ultimately end up choosing will have its own outcome. For example, think about two business buyers who have an eye on the same business but use different valuation methods. Each buyer will have different opinions about what risk is, and how much they are willing to take on. They will have their own perceptions about what is most valuable to them, and where they see the future of the business.
Even if they end up using the same valuation methods, the results still might differ. This is known as the Investment Value standard. In this context, each buyer of the business is considered to be an investor and therefore measures the value of the business based on their individual investment goals.
Which one should you use?
The bottom line here is that business value is ultimately in the eye of the beholder. What is a good deal for one person, may not be so good for another. If you are buying or selling a business, it’s best that you use a range of valuation techniques to get the best possible picture of the business worth and potential. By using only one avenue of valuation, you might not be able to make a completely informed decision.
How can I maximise my valuation?
If you want to sell your business, you’ll naturally want to get the best possible price for it. For more information, read our article on Five Ways to Maximise Your Business Valuation. And, when the time comes, talk to us about our other Business Finance solutions to position yourself in the best way possible.